What is a Deferred Sales Trust?
A Deferred Sales Trust is a capital gains tax strategy asset holders can use to delay paying capital gains taxes and maximize the return on their investments. The Deferred Sales Trust (DST) is a contract between the asset holder and a third party (the trust) where you sell assets (such as homes, businesses, or stocks) to the DST in return for a promissory note that entitles you to future payments over a time period that you determine. These payments are known as installments. Using this method, investors can defer paying capital gains taxes on their appreciated asset for a period of time or even indefinitely.
How Does a Deferred Sales Trust Work?
The term “Deferred Sales Trust” doesn’t exist anywhere in the US tax code. Rather, it is a specific form of an “installment sale.” Let’s say you buy a house for $500,000 and then one year later sell it for $1,500,000. Your capital gains would be $1,000,000. You would be responsible for long-term capital gains tax on the sale at a rate of 20%–meaning that you could owe the federal government $200,000 and states like California an additional 13.3% around $130,000.
Rather than receive your capital gain in a lump sum and then owe the IRS and the state of California that $330,000 all at once, you can choose to use a DST to defer your capital gains tax. Instead of selling your house directly to the buyer, you sell it to the trust, which disposes of your asset for you. Then, you can choose to realize your gains from the trust gradually over time or only receive interest payments and put off realizing all of your gains indefinitely.
Why Should I Defer My Capital Gains Taxes?
The income generated from a Deferred Sales Trust is still subject to taxes. However, by delaying the realization of capital gains, the income is distributed over a more extended period, and the tax liability may be smaller than if receiving a lump sum in a single year.
A DST allows individuals to delay when there will be capital gains tax exposure by structuring the payout over time via an installment sale. The asset owner can reduce his tax liability by strategically determining when to receive the gains. Or, if the owner wants income but wants to delay realizing capital gains indefinitely, the promissory note can be set to pay interest-only payments on reinvested assets with a balloon payment due in year 10; however, the note can be refinanced for another 10 years, every 10 years.
What Assets Qualify for a Deferred Sales Trust?
Unlike a 1031 exchange, a Deferred Sales Trust allows for a wide variety of assets. It is most effective for assets that have seen significant appreciation. It is most commonly used for real estate, businesses, and securities sales. It can also be used for cryptocurrency, artwork, collectibles, and intellectual property.
How to Set up a Qualified Deferred Sales Trust
Structure of the Trust
To qualify, the Deferred Sales Trust must be a legitimate third-party trust with an actual third-party trustee.
Independent Trustee
The third-party trustee cannot be connected with the owner or beneficiary of the trust in any way. That means there cannot be any familial or business connection outside the trust itself. If there is no legitimate independent trustee, the IRS will consider this a “sham trust” set up to avoid taxation. The trustee is contractually obligated to manage the trust according to the goals and risk tolerance of the beneficiary and to abide by all the regulations governing trusts.
Transfer of the Asset
In order to defer 100% of the capital gains tax, the owner must not take any actual receipt of proceeds from the sale of the asset. A Seller can take partial amounts from the sale where they will pay capital gains tax on the amount received. The trust receives the sale proceeds directly from the disposition of the asset that unlocks capital gains tax deferral.
Ownership of the Asset
The ownership or interest of the asset must be legally sold to the trust before the sale of the asset to the 3rd party buyer. If you do not sell the asset to the trust before the close of escrow and instead retain ownership, the IRS can disallow the treatment of installment sale and and tax the seller of the asset as it normally would.
Trust Investments Options
The trust can invest in any asset of any kind at any time. This gives diversification.
Drawbacks of a Deferred Sales Trust
Are there any disadvantages to using a DST? There are a few facts to consider as you decide if a Deferred Sales Trust is the right approach for you.
Delays Rather Than Eliminates Taxes
It is worth emphasizing that while a DST can be an effective strategy to delay paying capital gains taxes, it does not allow you to avoid taxes altogether. As you receive payments from the trust, you will pay ordinary income tax on them. If the payments include principal, these amounts will be subject to capital gains tax.
Complex to Set Up
Most tax deferral programs take some work to set up, but the Deferred Sales Trust can be more complicated to set up and manage correctly than other tax deferral forms. That is why it is important that you work with a qualified Deferred Sales Trust expert to ensure that you are maximizing your returns.
Potential for Mismanagement
If your Deferred Sales Trust is not properly managed according to IRS regulations, it will be deemed a “sham trust,” and the profits from the sale of your assets will be taxed at the full capital gains rate. This is why it is crucial that you use an experienced and knowledgeable DST trustee to manage your trust and help you get the most out of your assets.
Takeaway
If you are looking to defer your capital gains on real estate, stocks, a business, cryptocurrency, or personal property, a Deferred Sales Trust might be the best approach for you. However, for a DST to be effective, it needs to be set up correctly, or the IRS will catch it, and you will be stuck paying the full tax rate on your capital gains. With over 30 years of experience, we can analyze your financial situation and recommend the best capital gains tax solution. If warranted, our team of experts can help you set up a Deferred Sales Trust to give you financial freedom and assist you in achieving your financial goals.
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A Deferred Sales Trust is a strategy that asset holders can use to delay paying capital gains taxes and maximize investment returns. Find out how to set up a qualified deferred sales trust in this infographic.
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